John Whitehead's Commentary

It could probably be shown by facts and figures that there is no distinctly native criminal class except Congress.--Mark Twain

In the aftermath of the economic boom of the 1990s, the United States faced countless corporate scandals. Due to the media attention given to them, issues like insider trading came to light.

Now with Senate majority leader Bill Frist (R-Tenn.) dumping all his stock in the nation's largest for-profit hospital chain, thus making millions, the issue of insider trading has once again come into public view. Precisely a month later, after Frist sold his stock, the price tumbled 9% when executives in the company--HCA Inc., which was founded by Frist's father and on whose board Frist's brother served--disclosed that hospital admissions of insured patients were lower than expected, depressing profits in the second quarter.

The timing of Frist's sale raised obvious questions about whether Sen. Frist had somehow traded on information he obtained in advance from the company. "Frist has been in the Senate for many years now, and the conflict is not new," said Melanie Sloan, executive director of the watchdog group, Citizens for Responsibility and Ethics in Washington. "Why did he decide to sell it then? Why not years ago? What changed? Did he know the stock was about to take a fall?"

Insider trading, roughly defined as trading on non-public information obtained through an insider, has been on the rise over the last half century. With the Securities and Exchange Commission's persistent attack on the popular celebrity Martha Stewart, the public quickly learned of this common practice. Although corporate executives and other high-profile citizens have been pursued, very little has been said about the possibility of insider trading within the halls of the United States Congress. Even though some well-known representatives have lucratively cashed in on investments during their time in office, amazingly no official inquiry into possible wrongdoing has ever been conducted.

The stock market, which is often advertised as a way to make lots of money, is viewed by most analysts as something much less promising. In what researchers call the "efficient market hypothesis," the stock market essentially is impossible to beat without inside information. This is true even with the technology boom, especially the internet, where public information about the stock market and its companies is literally available to anyone at anytime. Indeed, by the time an investor finds out all the necessary information to invest in a promising company, that information has been viewed by thousands of stock brokers, and institutional investors have already purchased thousands of shares. And by the time an investor purchases the stock, its price may have already soared to a level where he will see minimal return on his investment.

There are, of course, exceptions to the rule. But generally, if an investor does enough trading on public information, his returns will not be overly significant. Essentially, the only way to consistently see huge returns on an investment is through the illegal practice of insider trading. This raises the question as to how U.S. Senators have recently had significant levels of success in the stock market.

A recent study by Dr. Brigitte Ziobrowski, published in the Journal of Financial and Quantitative Analysis, shows an alarming success rate among senators who invest in the stock market. The study used disclosed information about senators from 1993 to 1998, looking at 6,000 common stock transactions, and determined that senators beat the market by 12 percentage points per year while the average American investor underperformed on the market by 1.4% during this same period. Ironically, corporate insiders, who would be expected to do well, only beat the market by six percentage points per year. As Dr. Ziobrowski writes, "Put another way, a typical investor who matched the S&P's performance for those years collected about $220 in profit for each $100 invested while the average senator...collected $460 on a $100 investment."

This study also looked at the timing of each sale or purchase and indicated that senators seemed to know the perfect time to buy or sell as well. "Senators would buy stocks just before the shares suddenly would outperform the market by more than 25%, conversely, senators would sell stocks...when the shares would fall back in line with the market's performance." Although this study uses older data, two of the most successful investors during this time were Senators John Warner (R-Va.) and Barbara Boxer (D-Calif.), who are still in the Senate today.

All this data would seem to show that some senators are, more than likely, trading on insider information. Senators essentially find themselves privy to information that is usually known only by corporate executives. They know when there will be changes in tax laws and when big government contracts will be handed down to certain companies, not to mention their constant socialization with corporations as well. In fact, the head of the SEC's Philadelphia office says, "Legislators are exposed to reams of confidential information--it's the nature of what they do." As Dr. Ziobrowski says, "the data suggests there is cheating going on, at a 99% level of confidence." And another study performed by the University of Memphis shows that about 75% of all stock transactions taken by randomly selected members of Congress directly coincided with their legislative activity.

The key difference between the information received by senators and that received by corporate executives is that the executives are severely limited in what they can do with the information. Senators, on the other hand, can trade stock without any restrictions such as reporting to the SEC every transaction they partake in, such as a corporate insider would.

There are supposed to be limitations on the type of transactions a government official can participate in. The Senate Code of Conduct says that senators "may not use official position to introduce or pass legislation, where a principal purpose is to further a...member's financial interest." The Code of Ethics for the U.S. Government Service goes even further in saying a representative should "never use any information coming to him confidentially in the performance of government duties as a means for making private profit."

One would assume that the code of ethics would bar any self-dealing or profit-making, but in reality it actually gives senators more leeway. As one researcher concludes: "Congress has excluded investment income, such as stocks, from ethics limitations on income...The result is that members routinely make killings in the market in areas where they legislate."

Although the study by Dr. Ziobrowski and his colleagues was published almost a year ago, the SEC has had a copy since March of 2004. Nevertheless, the SEC has continually refused to investigate insider trading among representatives in Congress because they say it is very difficult to win these types of cases without more detailed knowledge than they already have. However, the public revelations concerning Frist have forced the SEC to look closer at the Senator's dealings.

Even in the face of the SEC's investigation of Frist, Dr. Ziobrowski admits that it is extremely difficult to determine how these senators received such abnormal returns. "I can envision a hundred different ways...a phone call from a friend at the FDA or Pentagon; there's a wide variety of vehicles that could be used here." Regardless of how difficult it is to prove insider trading, the SEC has the resources and the expertise to conduct this type of investigation. It seems rather ironic that the SEC was ruthless in its pursuit of Martha Stewart for about $100,000 but is unwilling to conduct an investigation into the same type of conduct within the U.S. Senate.

There is no question that the SEC has taken on a more intrusive role in recent years to crack down on corporate crime and insider trading. It is also understandable that insider trading is extremely difficult to investigate and prove. The recent studies, however, should have raised enough suspicion for the SEC to at least take a deeper look into senators' private transactions. If this study had been conducted on a group of average investors with no political clout, like you and me, it is highly likely that the SEC would have conducted a thorough investigation and, eventually, prosecuted the guilty.

ABOUT JOHN W. WHITEHEAD

Constitutional attorney and author John W. Whitehead is founder and president of The Rutherford Institute. His most recent books are the best-selling Battlefield America: The War on the American People, the award-winning A Government of Wolves: The Emerging American Police State, and a debut dystopian fiction novel, The Erik Blair Diaries. Whitehead can be contacted at staff@rutherford.org. Nisha Whitehead is the Executive Director of The Rutherford Institute. Information about The Rutherford Institute is available at www.rutherford.org.

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